The Little Book of Big Dividends

A Safe Formula for Guaranteed Returns

Charles B. Carlson

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470625385
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Everyone needs to invest, but where do you invest during bear markets?

The massive stock declines over the past year have eroded savings, but this doesn't mean you should stuff your money under a mattress. It needs to be put to work getting some return so that it will grow.

Smart investors will turn to high dividend paying stocks to get a stable and growing stream of income. Dividend investing-that provides an income beyond any gain in the share price-may be the investor's best weapon. Dividends are safe, largely reliable, and maybe at the their cheapest levels in many years. While the best paying dividend stocks of recent years, such as financials, took a huge beating in 2008, opportunities will abound in 2010 and beyond-if you know where to look.

In The Little Book of Big Dividends, dividend stock expert Chuck Carlson presents an action plan for dividend-hungry investors. You'll learn about the pitfalls, how to find the opportunities, and will learn how to construct a portfolio that generates big, safe dividends easily through the BSD (Big, Safe Dividends) formula. If you're a bit adventurous, Carlson has you covered, and will teach you how to find big, safe dividends in foreign stocks, preferred stocks, ETFs, real estate investment trusts, and more.

• Contains the simple tools, strategies, and recommendations for finding big, safe dividends
• Helps you put a complete portfolio together that pays dividends every month
• Show you the top dividend paying stocks with their dividend payment dates

It doesn't get any easier than this, and in these turbulent times, you can't afford to ignore the power of dividends. Read The Little Book of Big Dividends and gain a better perspective of how you can protect yourself for the future.

Chapter One

The Check Is in the Mail

Get Paid to Invest with Dividends

The controller of my company is named Pam. Besides being a great controller, Pam has a great smile, one of those toothy ones that lights up a room. I always enjoy seeing Pam’s smiling face, especially every other Friday. Everyone in my company loves to see Pam’s smiling face every other Friday. That’s when Pam hands us our paychecks.

Payday never gets old. I don’t care if you’ve worked a week or a lifetime. Payday is always a great day, a day never to be taken for granted.

Why is payday great? Besides the obvious, payday represents that weekly, biweekly, or monthly validation that what we do matters, that we aren’t simply wasting our time, that we are adding value.

Of course, you may feel other emotions on payday—perhaps jealousy, maybe a little resentment. Still, getting paid is really why we do anything. The pay may not always be in dollars. The currency may be that buzz you get when you volunteer your time, coach your daughter’s softball team, hike your favorite trail, or send that check to your favorite charity.

Getting paid is why we get up every morning.

And getting paid is why we invest.

Investing may not always feel this way. I didn’t exactly feel as if I was getting paid to invest in 2008. It felt as though I was doing the paying. Still, we invest to get paid. Otherwise, we wouldn’t do it.

How do we get paid for investing? Two ways:

1. The value of our investment goes up. You buy a stock at $10, and it jumps to $20. You made $10 on your investment. That $10 profit is called a capital gain. If you sell and lock up the profit, you have a realized capital gain. If you still hold on to the stock, you have an unrealized gain.

2. We receive a portion of the company profits on a regular basis. As a shareholder of a company, you’re an owner. As an owner, you have a claim on the profits of the company in proportion to your ownership. The board of directors of your company may choose to keep those profits and reinvest them back in the company. On the other hand, the board may decide to distribute part or all of the profits to the owners. Let’s say a company’s board has made the decision to disburse 30 percent of its profits that year to shareholders. If profits are $2 million, shareholders receive $600,000. Your claim on that $600,000 depends on your percentage ownership. If you own 1 percent of the company, you’ll receive $6,000. That $6,000 is commonly called a “dividend.”

Dividends are usually paid quarterly (every three months), although some companies (especially foreign firms) pay dividends only once or twice per year. Companies may differ in the months when they pay their dividends. Some companies pay dividends in March, June, September, and December; some pay in February, May, August, and November; others pay in January, April, July, and October. Knowing the dividend-payment dates can be useful when constructing a dividend portfolio to provide regular cash flows to meet financial obligations. I’ll show you how to construct “dividends-every-month” portfolios in Chapter 7.

A stock’s total return—the total amount you get paid for investing—is capital gains plus dividends. Let’s say you own a stock that goes from $10 per share to $11 per share in a year. During the year, the stock paid $0.50 per share in dividends. The stock’s total return for the year is 15 percent ($1 per share in price appreciation plus $0.50 per share in dividend divided by the starting value of $10 per share).

As you can see, dividends represent an important component of a stock’s total-return potential. In fact, roughly 40 percent of the stock market’s long-run total return comes from dividends.

Roughly 40 percent of the stock market’s long-run total return comes from dividends.

Why Dividends Matter

When you examine the two ways of getting paid to invest—capital gains and dividends—it’s natural that dividends have special appeal. A stock’s capital-gains potential is influenced significantly by what the market does in a given year. Sure, stocks can buck a downward market. But most don’t.

On the other hand, dividends are usually paid whether the broad market is up or down.

The dependability of dividends is a big reason why investors should consider dividends when buying stock. I’m not suggesting that every stock you own must pay a dividend. However, there’s something to be said for the bird-in-hand theory of investing—that a steady, dependable dividend stream provides nice ballast to a portfolio’s return. Procter & Gamble, the consumer-products giant, has paid a dividend every year since 1891. Procter & Gamble’s stock price has not risen every year since 1891. But shareholders who owned the stock at least got paid a little during those down years. They weren’t totally dependent on capital gains to get paid.

Another attraction of dividends is that they can grow. Johnson & Johnson, the health-care company, has raised its dividend every year for more than 45 years. Shareholders received those growing dividends regardless of what happened to the stock price in a given year. And the rising dividend stream not only hedged against inflation but also accelerated the payback on investment.

Here’s an example of what I mean by payback on investment. If you had invested $5,000 in Johnson & Johnson at the beginning of 1985, held the stock until today, and reinvested dividends along the way, your annual dividends from J&J stock would now be more than $7,100. In other words, your payback on your initial investment via dividends is more 100 percent every year.

Now that’s the power of dividends in an investment program.

To Pay Dividends or Not To Pay Dividends

The stock market is really a market of a bunch of small companies. Probably 80 percent or more of all publicly traded stocks have market capitalizations—market capitalization is figured by multiplying outstanding shares by the per-share stock price—of less than $1 billion. In fact, a healthy chunk of all publicly traded companies have market caps that are less than $100 million. Fewer than 300 companies have market caps above $10 billion.

In short, the typical stock is not IBM or Microsoft or Exxon Mobil. The typical stock is one that you probably never heard of, one in which the firm is quite small and in its primary growth mode.

When you understand that the stock market is really a market of very small companies, you understand why the majority of publicly traded companies don’t pay a dividend. A dividend represents an outflow of assets to shareholders. Once dividends are paid, the money is gone, and the firm can no longer use that money to fund growth. Small and growing firms often choose to retain profits in order to have the cash to fund their growth.

Another reason why smaller companies may not pay a dividend is because of the variability of their profits. Small companies may be dependent on a few customers. If orders dry up from one customer, so too do revenues and profits. Implementing a dividend initiates an implicit contract with shareholders, a contract that says that you can depend on this dividend through thick and thin. True, this contract has been a bit frayed by the dividend cuts and omissions seen since late 2007. Historically, however, companies have been extremely reluctant to cut or omit a dividend. Therefore, if a firm is not confident in the stability and dependability of its profit stream, it is unlikely to initiate a dividend.

So what firms pay dividends? They are generally larger, more established companies. Dividend-paying companies have probably experienced their biggest growth spurt and don’t require all of their cash flows to fund their operations. Such companies are reasonably confident that their future profitability will support a dividend payment.

Of course, there are exceptions to every rule, and plenty of smaller companies pay dividends. Still, out of the some 4,000 firms my firm tracks via our Quadrix stock-rating system (I’ll tell you about Quadrix later in the book), less than 38 percent pay dividends. And those dividend payers tend to have market capitalizations, on average, of $8.4 billion versus the average market cap of non–dividend-paying stocks of $1.5 billion.

No Profits, No Dividends

A stock’s dividend represents the cash flows companies pay their common shareholders. These cash flows are ultimately paid out of profits or, technically, “retained earnings” of the company. That’s pretty basic stuff, right? It’s obvious that if a company doesn’t generate profits, it probably isn’t generating the cash flow that can be used to pay dividends. Yet you’d be surprised how many investors tend to ignore the relationship between profits and dividends when choosing dividend-paying stocks.

Dividends are ultimately paid out of a company’s profits, so pay attention to the relationship between the two.

You may have owned companies that had a bad year but still paid their dividend, but that’s not a game that can be played indefinitely. Companies can borrow money to pay their dividend. They can dip into cash reserves to pay their dividend. But at some point, a firm that isn’t earning its dividend will not pay the dividend.

A useful tool for examining the relationship between profits and dividends is a stock’s payout ratio. The payout ratio reflects the percentage of a company’s earnings that are paid out in the form of dividends. A firm that has profits of $2 per share and pays $1 per share in dividends has a payout ratio of 0.5 (1 divided by 2).

The higher the payout ratio, the more danger the company is in of reducing or eliminating the dividend if problems develop. The payout ratio is the single most powerful factor in analyzing the health, stability, and growth potential of a stock’s dividend. For that reason, the payout ratio carries the highest weighting in my Big, Safe Dividend (BSD) Formula discussed in Chapter 3.

What’s My Yield?

Many investors like to compare dividends on stocks to the interest paid on bank CDs or money market accounts or the coupon payments paid on bonds. Although this is a bit of an apples-to-oranges comparison (the risks of stocks are decidedly greater than the risks of bank CDs or most bonds), the comparison is useful for understanding the concept of yield. The yield on your money market account is the same as the interest rate; that is, if you put $1,000 in a money market account that promises to pay you $20 in interest over the next year, the interest rate (or yield) is 2 percent ($20 divided by $1,000).

A stock’s dividend yield is computed the same way. You take the amount of dividends paid over the last year and divide by the stock price. For example, a stock that trades at $10 per share and paid $0.50 per share in dividends over the last 12 months has a yield of 5 percent ($0.50 divided by 10).

Most investors use a stock’s indicated dividend to compute yield. The indicated dividend is computed by taking the stock’s most recent dividend payment and annualizing it. Thus, for a stock that paid $0.25 per share in its most recent quarter, the indicated annual dividend would be $1 per share ($0.25 multiplied by four quarters if the company pays quarterly dividends). And if the stock currently trades for $20, the indicated yield is 5 percent ($1 divided by $20).

While important, yield should not be the primary determinant for stock selection. Investors too often ignore the fact that yield is a pretty good proxy for risk. An unusually high yield can foreshadow big problems at a company. In fact, a high yield is an excellent predictor of dividend cuts or omissions. I’ll discuss more about the relationship of yield and risk in Chapter 2.

No Free Lunch

While dividends are often referred to as an investor “free lunch,” that’s not exactly true. A dividend is not free money for shareholders. A company cannot pay out dividends to shareholders without affecting its market value.

Think of your own finances. If you constantly paid out cash to family members, your net worth would decrease. It’s no different for a company. Money that a company pays out to shareholders is money that is no longer part of the asset base of the corporation. It’s money that can no longer be used to reinvest and grow the company. That reduction in the company’s “wealth” has to be reflected in a downward adjustment in the stock price.

You may be surprised to learn tha...